I-5 Investment Risk Management Update

Transcription

1 I-5 Committee on Investments / Investment Advisory Group September 10, 2009

2 Outline Overview of Pension / Endowment Risk Management Risk Management at UC State of Risk Management today Future Directions for Risk Management Sept 10,

3 What Is Investment Risk? Investment Risk is the potential for loss accepted by an investor in order to earn a return Risk is characterized by The range of possible negative outcomes (losses) The likelihood of those outcomes The impact of loss on the organization Risk tolerance articulates the magnitude of loss an investor is willing to sustain in order to generate an acceptable return Sept 10,

4 Framework for Risk Management Bearing risk is an essential part of investing Risk in itself is intrinsically neither good nor bad; risk is a scarce resource used to generate investment returns Risk management is not about eliminating risk, but balancing risk and expected return The essence of investment management is the management of risks, not the management of returns You can t control outcomes, you can only manage risk Risk forecasts are not forecasts of losses; they are conditional forecasts of potential loss Sept 10,

5 Risk Management Value-Added Ensure that sources of risk ( risk factors ) are identified, understood, and quantified Ensure that assumption of risk is intentional and consistent with investment objectives Ensure that risks are adequately compensated (expected return is commensurate with risk) Enable fiduciaries to assume the amount of risk consistent with investment objectives and standards of prudence Sept 10,

6 Outline Overview of Pension / Endowment Risk Management Risk Management at UC State of Risk Management today Future Directions for Risk Management Sept 10,

7 Mission/Objectives Mission To ensure that the investment activities do not expose the University to potential or unexpected losses beyond the Regents risk tolerance levels Objectives Identify and bound possible losses for all portfolios Develop and monitor guidelines and limits on the investment process to maintain the probability of loss within acceptable limits Sept 10,

8 Risk Management Roles Fiduciaries approve investment policy Express tolerance for risk Asset allocation, benchmarks, guidelines CIO/staff implements policy Maintain asset weights within set ranges Select strategies and managers Allocate risk to various strategies Risk management ensures policy is followed Risk exposures are appropriate and properly diversified Risk is adequately rewarded Sept 10,

9 Risk Measurement and Models Measuring risk is not as simple as computing past ( realized ) volatility of returns However, volatility is useful to know: it indicates the range of past outcomes A risk measure is an estimate of future potential losses, given current conditions A risk model is a methodology to measure risk for portfolios based on the current holdings Sept 10,

10 Risk Measurement and Models continued We use factor models which identify common sources of risk among similar securities E.g., common movement of all stocks in an industry E.g., credit quality of corporate bonds Risk measurement consists of: Exposure to risk factors Volatility of those factors Co-movement of risk factors Risk and risk measurement is multi-dimensional Sept 10,

11 A Common Language The innovation of risk management is a common framework and uniform metric to quantify all investment decisions Allowing us to trade-off risk in one area with risk in another A risk budget is an optimal allocation of a given level of risk to various investment choices If we have used up our risk budget, we must reduce risk in one or more strategies in order to take risk in another one Sept 10,

12 Traditional Management of Risk Managing investments has always been about managing risk Traditionally done with inefficient guidelines and constraints, e.g., Position and sector limits Limits on manager size Long only constraint No derivatives Credit limits These are all examples of risk proxies Why not manage the risk factors directly, and link risk to expected return? Sept 10,

13 Why Is This Inefficient? Constraints are proxies for risk; crude (but sometimes effective) risk controls They don t account for actual contribution to risk of different positions Constraints don t account for volatility, correlations, or hedges Constraints cannot be combined or traded off against each other Sept 10,

14 Outline Overview of Pension / Endowment Risk Management Risk Management at UC State of Risk Management today Future Directions for Risk Management Sept 10,

15 Are the Risk Models Broken? The risk models used at the Office of the Treasurer are not the same as the models the Rating Agencies used to give AAA ratings to CDO s backed by sub-prime mortgages However, all risk models use the past volatility of securities and markets as inputs to generate forecasts The period preceding the decline experienced low volatility, and so most risk models underestimated the range of possible outcomes Experience is a hard teacher; she gives the test first and the lesson afterwards Sept 10,

16 Emerging Consensus Risk measures should be somewhat counter-cyclical To enable Buffet-type contrarian strategies Develop risk measures which are less dependent on price movements Incorporate macro-environmental signals Focus on avoiding loss, rather than reducing volatility Use models appropriately, to ask questions not to give answers Continually question What assumptions are built into our models? What if we are wrong? (to balance overly optimistic portfolio managers) Sept 10,

17 Outline Overview of Pension / Endowment Risk Management Risk Management at UC State of Risk Management today Future Directions for Risk Management Sept 10,

18 What Can t We Do Better? Predict when market indexes will decline precipitously Predict turning points in market indexes Predict how long trends will continue Trends in return Trends in volatility Trends in co-movement of risk factors Sept 10,

19 What Can We Do Better? Combine economic and asset valuation signals in risk forecasts Focus more on total risk, as well as risk relative to the benchmark Recognize the limits of the normal distribution in measuring and interpreting risk (e.g., fat tails ) Replace correlations with more general measures of return co-variation Focus more on downside risk, and on the explicit trade-offs of adopting a more conservative position when risk measures decrease but risk seeking behavior increases Sept 10,